Beating the Market Addendum: Taxes

A few days ago, I wrote about how programmers can beat the market in their investments

The key is to invest in yourself and either increase your value in the labor market or sell products. If you think of the extra income you earn as “market return”, then you can easily add a few percent to your overall return with minimal risk of downside.

But the astute among you might have realized that income is tax disadvantaged vs. capital gains (from stock returns). And, that if you buy and hold stocks, then you can defer taxes. But if you make income, you need to pay taxes immediately.

And since I am advocating you getting side income or raises, this extra income is at your highest income tax bracket.

DISCLAIMER: I am not a CPA or financial advisor and even so, it is May 2021, so everything I am saying is possibly not true if you are reading this in the future. Also, this is US only. Check with your accountant to see what the effect is to you personally. Also, I am intentionally simplifying some things because the actual tax law is way more complex than this.

Also, my original article and this one assumes you are a programmer, which is why my salaries in the example are 100k and over 140k. A lot of this math doesn’t work unless your salary is in that range. At lower income, long term capital gains tax is 0%.

For this analysis, I am assuming you are single. The numbers are different if you are married, but the idea is the same.

Here’s an example:

Let’s say you make a salary of $100k, and you get $10k of extra income. If you are single, that $10k has federal tax of about 24% and FICA of 7.65% (you may also have state taxes). If you get this money via consulting or selling products, you pay another 7.65%. The total rounds up to 40%. (BTW, I know it’s more complicated than this, but this number is approximate)

But if you buy and hold stocks that go up an extra $10k over the market, your tax bill is $0. You only pay tax if you sell stocks. So, eventually, when you do sell them, it will probably be 15% long-term capital gains. Again, it’s more complicated than this, and in 2031, when you sell, who knows what the tax law will be, but 15% is our current best guess.

So, of the extra $10k, you keep about $6k if it’s side income, $6.8k if it’s a raise, and eventually $8.5k if it’s market gain.

Now, if you day trade stocks or bitcoin and don’t hold your positions for a year, then the gains are taxed at the same rate as wage income, so 24% in our case (no FICA). So you keep $7.6k instead of $8.5k.

You still pay less tax trading, but the good news is that it’s not that simple. 

I’m ignoring state tax, because mostly that’s a wash, but you need to check because in Massachusetts, short-term gains get taxed at 7% more than wage income (12% vs 5%). I live in Florida, which doesn’t tax income or gains. So, it could make a big difference depending on where you live.

The biggest tax savings are from maxing out your social security tax.

I used $100k base salary, but in 2021, if you make $142.8k, you max out your social security tax and only pay the Medicare portion on your side income, so that’s 2.9% instead of 15.3%. Your tax bracket is about the same, so now you pay 27% of the total vs. 24% for a day-trader. If the new income is a raise, then you pay 1.45%, so a total of 25.45%.

If your new income is a raise, you can further lower your taxes by increasing your 401k (or other tax deferred) contribution. If you get a $10k raise, and can put all of that in the 401k, then your tax rate is 1.45% for Medicare. 

To be fair, as long as you have enough wage income, you could effectively do this with your market return by contributing the equivalent amount of wages, so it’s a wash. But I want to mention it because it’s the first thing you should consider doing with extra income no matter how you get it.

If you make the money on the side, you can lower your taxes in ways that don’t apply to market returns.

There’s a QBI deduction of 20% on net business income. So, you only pay tax on $8k of the side income. So it’s an effective rate of ~22%. 

Now we just beat the day traders who pay ~24%. 

But what about the stock pickers that buy and hold? We still have to make $11k for each $10k they make (again, that’s not hard).

Even if you max out your 401k, you can put 20% of your net business income in a solo 401k (or other business tax deferred vehicle).

So, if you make $10K, you could put $2k in the solo 401k, deduct $1.6k (QBI) and only pay the 24% tax on $6.4k and another 2.9% on the $10k. So your effective take-away is about $8.2k, with an effective tax of 18%.

Remember, this is all approximate, I am not a CPA and there are more things to take into account. For example, you eventually pay tax in retirement on the money in the 401k.

Also, I didn’t take any normal business deductions into account, like home-office, computer, tech books or courses, business group membership fees, etc. If you can deduct about 5% of the income, your effective tax rate on the side income is lower than 15%.

But the takeaway is that you can get your tax bill in the same range of the day traders with extra wage income if you already max out your Social Security contributions. It’s not as tax-disadvantaged as it seems at first.

The traders pay something between 15%-24% depending on how long they hold, and you pay something between 18% and 27% if you max out Social Security at your day job. And you can get it even lower with business deductions.

You do need to add another 12.4% if you don’t max out SS—so go get a raise to get you closer to maxing out.

Of course, you lose the option of negative tax that comes from stock picking losses, but we can live with that.